Federal Reserve policymakers are widely expected to raise short-term interest rates this week. The policy statement should continue to suggest that, while the pace of tightening is expected to be gradual, action will remain data-dependent. As Chair Yellen recently testified, the Fed will not attempt to anticipate fiscal stimulus that may come from the new administration and Congress, but will respond to implications that tax cuts or additional government spending may have on the economic outlook. Chair Yellen’s four-term as chair ends in early February 2018. Personnel changes on the Board of Governors could have significant implications for the Fed over the next couple of years.
The Fed has worked hard on its communications in recent years and is much more open than it used to be. However, the central bank still has problems with how its messages are received. For example, former Chair Ben Bernanke would often make some conditional statement such as “A, but B.” Market participants would either hear the “A” or the “B” but not appreciate the subtleties (markets don’t do nuance). The dot plot, projections of the appropriate year-end federal funds target rate produced at every other FOMC meeting, is pretty simple. It shows the range of policy estimates for each senior Fed official (the governors and the 12 district bank presidents). There is a wide range among the forecasts and considerable uncertainty surrounding each of the dots. Officials do not know precisely how the economy will evolve in coming quarters. The correct answer to the question of where the Fed is headed is always “it depends,” but market participants have often viewed the dot plot as a plan of action. It’s not.
Over the last several quarters, the dots in the dot plot have consistently drifted lower, as the job market has tightened less than anticipated and inflation pressures have remained at bay.
This week, we ought to see little change in the dot plot relative to what officials were expecting in September. Recall than in September, most Fed officials expected to raise rates by the end of this year and most anticipated that there would be two rate hikes in 2017.
The Fed tries to reach decisions by consensus, but there are often divisions. Officials have been split. Most of the district bank presidents have wanted to raise rates sooner, while the governors, traditionally more pragmatic, have been cautious. By construction, the Federal Open Market Committee gives more power to the governors (the FOMC is made up of the governors in Washington, the New York Fed president, who typically sides with the governors, and four other district bank presidents, who rotate every year). The FOMC sets the target federal funds rate (the market rate that banks charge each other for borrowing excess reserves). Changes to the primary credit rate, often still called the discount rate (what the Fed charges banks for short-term borrowing), are requested by one or more of the district banks and approved (or not) by the Board of Governors.
Fed governors are nominated by the president and approved by the Senate. There are currently two vacancies on the seven-member board. Chair Yellen’s term as chair ends February 3, 2018, while her term as governor runs through January 2024 (theoretically, she could stay on if not re-nominated). Candidate Trump said he would replace her. Stanley Fischer’s term as Vice Chair ends June 12, 2018 (his term as governor ends in 2022). The three other governors have terms that last until 2022 or later. So, President Trump will be able to nominate two governors, and possibly replace Yellen and Fischer.
The most important aspect of the Fed is its independence. It is responsible to Congress (and, therefore, indirectly to the American people), but its decisions must remain free from political pressures. The last thing anyone should want is monetary policy being dictated by the executive branch or Congress. That is a recipe for disaster.
During the lead-up to the financial crisis, there was no systemic regulator – that is, no entity was in charge of supervising the whole financial system. Post-crisis, that role now belongs to the Federal Reserve. Hence, lawmakers will have more interest in seeing people with specific regulatory views put in charge at the central bank.
By the end of 2017, the focus should turn to Yellen’s successor. There is a lot at stake. Many Republicans have been critical of the Fed’s actions in recent years and may want somewhat more hawkish. At the same time, Democrats have the ability to hold up nominations, as the Republicans did during the Obama administration. There’s hope that we’ll see a nominee that both sides can accept. Maybe Yellen will stay.
© Raymond James
© Raymond James
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